The buzz of global commerce, the price of your morning coffee, or the cost of filling up your car's tank, all of which eventually find their way back to the enormous and fluid world of commodity markets. These markets are what we call foundational markets, where we trade raw materials and are the basis of all industries around the world. Knowing about commodity markets and their respective types is not only for seasoned investors, but rather fundamental for anyone interested in comprehending some of the driving factors of our economies and everyday lives.
So, what is a commodity market, and how many types are there? Here we go!
What is a Commodity Market?
In its simplest form, a commodity market is a marketplace for standardized raw materials or primary agricultural products in which the prices of those goods will vary depending on supply and demand. Instead of finished goods, commodities are standardized interchangeable goods; hence, a barrel of crude oil from Saudi Arabia is essentially a barrel that is worth the same as a barrel of crude oil from Texas. This interchangeability in commodities is what allows for the organized trading of them, along with the use of commodity contracts as a means of trade.
Commodity markets comprise an important mechanism for price discovery, allowing producers to hedge positions against future price changes of commodities, this allows consumers to establish a set price for a future delivery of a commodity. Commodity markets also provide a mechanism for speculation through market traders attempting to profit from a price movement or fluctuation.
How Many Types of Commodity Markets Are There?
While the general idea of a "commodity market" is one, there are many different ways in which we can categorize them, each offering a different look at what they are and how they work. We can categorize broadly in 3 ways: the commodity type, how it is traded, and the delivery method.
Hard vs. Soft Commodities
Of course, the most basic distinction in commodity trading is the hard/soft commodity separation. This classification is really based on the origin and attributes of the commodity.
Hard Commodities
Hard commodities are natural resources that are typically mined, extracted, or derived from the earth. Hard commodities are typically scarce and costly to extract and/or process. Because they are extracted from the ground, there is generally a lengthy supply cycle that is somewhat insulated against immediate environmental factors; however, political stability and a decrease in the efficiency of extraction mean commodities that were once abundant can experience much shorter supply cycles.
Some hard commodity examples are as follows:
Energy Commodities: The most common hard commodities are simply "everything energy." Think Crude Oil, Natural Gas, Coal. The energy commodity market is the key to industry and consumption on a day-to-day basis and absolutely impacts anything from transportation costs to electricity bills.
Precious Metals: Generally, think Gold, Silver, Platinum, and Palladium. Precious metals are thought of as safe havens, especially during economic instability, and they also magically turn into jewelry and industrial applications like electronics.
Industrial Metals: Examples of industrial metals are Copper, Aluminum, Zinc, and Nickel. These metals are vital for manufacturing, construction, infrastructure development, etc. Demand for these metals is often a signal of global economic health.
Soft Commodities
In contrast, soft commodities are primarily agricultural products and livestock. Soft commodities are grown or raised and therefore renewable resources, but they are also incredibly reliant on nature (weather, disease, seasonal), which makes soft commodity prices much more volatile in nature than other types of commodities.
Agricultural Commodities: A huge group of soft commodities, including staples such as Wheat, Corn, Soybeans, Rice, Coffee, Sugar, and Cotton. The agricultural commodity market will be important in relation to food security and associated industries.
Livestock: Examples of livestock are Live Cattle and Lean Hogs. Livestock is the market for meat and products associated.
Spot vs. Derivatives Markets
In addition to the type of commodity, markets will also be distinguished by how the commodity is traded. That brings us to the difference between cash/spot markets and derivatives markets.
Spot Market (Cash Market)
A spot market (or cash market) is where you can buy and sell the actual commodity for immediate delivery and payment at the current market price. It's an exchange done "on-the-spot". In a spot market, the exchange of goods and transfer of money are mostly concurrent. This market is essential for short-term supply needs for producers and consumers. In an example, a coffee roaster who has purchased coffee beans to make a batch of coffee would typically operate in the spot market.
Derivatives Market
The derivatives market has financial instruments whose value is derived from an underlying asset - in our example, a commodity. The derivatives market does not trade actual commodities; instead, it trades contracts that bind or allow parties to buy or sell a commodity at a predetermined price on some date in the future. Like the spot market, this market is the process of hedging against future price risk, and also the process of speculation on future price movements. If you are interested in learning more about the trading practices of this marketplace, you can read our article on How to Start Trading in Derivatives Market, and if you are interested in some more advanced ideas, then you need to understand Open Interest in Derivatives.
Key types of commodity derivatives include:
Futures Contracts: A contract for a legally binding agreement to buy or sell a specified quantity of a commodity at a predetermined price, on a specified future date. They are highly liquid and traded on organized exchanges.
Options Contracts: Options provide the buyer with the right, but not the obligation, to buy (call option) or sell (put option) a commodity at a specified price (strike price) by a specified date. Options provide some flexibility in managing risk.
Forward Contracts: Similar to futures contracts, forward contracts are typically customized, over-the-counter (OTC) contracts between two parties. They are less standardized than futures and carry higher counterparty risk.
Physical vs. Financial Settlement
Finally, in commodity markets, there are two ways of classifying transactions by the way it is settled at the expiry of the contract:
Physical Delivery
Physical delivery means that the buyer actually takes delivery of the physical commodity at the expiry of the contract. This is mainly used by industrial players, large-scale buyers, and producers that need or supply physical products. For instance, an airline may take physical delivery of aviation fuel, or a gold refiner may take delivery of gold bullion. Managing logistics like storage and transportation can now be a big consideration.
Financial (Cash) Settlement
Financial settlement, or cash settlement, is far more common for most non-commercial traders and speculators. As opposed to exchanging the actual commodity, the difference between the contract price and the market price at expiry is settled in cash. This way, participants are able to profit or lose based on the fluctuations in prices without having to even think about the logistics of needing to store barrels of oil or tons of wheat. This is a preferred method for those involved with commodity trading for speculation or price hedging, where the underlying asset is not required.
Why Understand Different Commodity Markets?
Recognizing the differences in these various commodity markets has a number of potential benefits for you, whether you are an investor, a business owner, or a simple, curious person:
Investment Diversification: Commodities do not typically react in the same manner as stocks and bonds typically do, so they really can be used to diversify an investment portfolio and can lower overall risk.
Inflation Hedge: The harder commodities, especially precious metals like gold, have historically been a hedge for inflation, meaning if a currency is getting devalued, the precious metal will retain or even gain value, preserving the purchaser's purchasing power.
Risk Management & Hedging: Producers (think farmers or mining operations) will utilize commodity derivatives markets to hedge against price movements detrimental to their position. Meanwhile, consumers (think airlines and food producers) will use hedging to manage price fluctuations, to obtain more predictable costs or revenue.
Speculation & Profit Opportunity: Commodity markets offer a wealth of opportunity for traders knowledgeable about price volatility stemming from supply-demand issues, geopolitical factors, and economic conditions. Topics covered in Top Technical Analysis Tools are useful for traders who wish to analyse and use a technical approach to something that is acting up. If you're looking to formalize your expertise across different financial instruments, you might also consider a dedicated Stock Market Training Course.
Comprehending Global Economics: Commodity prices can be leading indicators of global economics. A rise in copper prices, as an example, may indicate an increase in the volume of industrial production.
Conclusion
Commodity markets are confusing and broad, yet among the most significant features in the global economy. Commodities can be anything from the extraction of raw materials from the earth to agricultural products that feed the entire population of the world. These markets play an important role in price discovery, risk returns, and investment. Understanding the distinctions between hard and soft commodities, spot and derivatives markets, and physical and financial settlement will provide you with a decent understanding of how the cogs turn in the global economy. Whether you are contemplating being a participant in the commodity markets or are just trying to understand how the forces intermingle in the market, this knowledge will be very useful.
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